Chapter five

Financial analysis and project selection

Financial analysis is analytical work required to identify the critical variables which are useful
for likely to determine the success or failure of an investment. Its concern is to determine,
analyze and interpret all the financial consequences of an investment that might be relevant to
and significant for the investment and financing decisions. This unit discusses the viability of
projects from financial significance to stakeholders and to the economy in general. For this
purpose different statements such as resource flow and financial statements how then are and
financial analysis tools (NPV, IRR and payback period) are discussed in detail.
5.1 Purpose of financial analysis in project preparation
Investors transfer the liquid financial resources (his own personal selling or borrowed money)
into production assets with the objective of producing and obtaining future benefits. This
process is known as investment, along term commitment of scarce resources.

The long-term commitment by the investor needs the transformation of liquid financial
resources (own or borrowed) into productive assets for financing an investment project.
Project financing includes the design of proper financial structure, considering the adequacy
of the financial plan, and the optimization of project financing from the different actors or
beneficiaries point of view. Therefore, the scope and objective of financial analysis are to
determine, analyze and interpret all the financial consequences of an investment that might be
relevant for and significant for the investment and financing decisions.

Financial analysis is essentially undertaken for the following purposes:

1. It provides an adequate financing plan for the proposed investment
2. It determines the profitability of a project
3. It assists in planning the operation and control of the project by providing management
information to both internal and external users
4. It advises on methods of improving the financial viability of a project entity
5. It illustrates the financial structure of the project and its existing and potential financial
viability.

Therefore, the purpose of financial analysis is not just to document the expected impact of the
project, liquidity, credit worthiness, financial efficiency, etc, of the various agents involved; it
should also be part of the process of project design itself.
5.2 Methods of financial analysis
To assess financial viability of a project a range of tools and methods can be used and various
types of financial statements can be prepared. This includes:
1. Resource flow statements
2. Profit and loss statements

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 3. Cash flow statements and
4. Balance Sheet
These statements are explained in detail below.

5.2.1 Resource Flow Statements

The starting point of the financial analysis of a project is drawing up of a statement of project
cost and benefits. The benefit and cost items included in the statement should include only
those items, which are incremental. The resource flow statement shows: (1) the list of
resources used in the project and (2) the resources generated by the investment on the project.

The major elements of resource flow statements are:

1. Investment costs:
costs: investment costs cover capital expenditure items such as land,
buildings, equipment and furniture etc. It includes three group of costs:
(a) Initial fixed investment costs. This includes investment made for the
acquisition of land, development of land for construction purpose, civil works
(laying the foundation), equipment and machinery costs, installation of the
machines or the plant, vehicle, furniture, building etc. All these above costs are
subject to depreciation except land which is depleted over time.
(b) Pre-production capital expenditure. The pre-production capital expenditure
includes:
- Research and development
- Pre-feasibility or feasibility study cost
- Training costs incurred before the commencement of the operation
- Recruitment of personnel costs
- Arrangement for marketing of the product such as early advertisement to
inform the public in advance before the actual distribution of the product
to the market
- Arrangements for supplies etc.
(c) Working capital. Working capital is simply a revolving fund. It is the
difference between current asset and current liability. This is known as a
circulating fund because at the end of the project's life it can be put as a benefit
of the project. Defining the working capital requirement appropriately is
important because many projects fail while they are in operation due to
shortage of cash or working capital. The amount of the total working capital
required depends upon the operating costs for the project.

There are three basic components of physical working and capital inventories
needed for production to be continuous. These are:
- Initial stock and materials
- Work-in-process and
- Stock of outputs

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 When these three components of working capital have been estimated, they
can be summed to give the total working capital requirements in any year. The
working capital resources that need to be included in a project statement are
the incremental amount (additional commitment of resources) as the
inventories build up or vary from year to year.

Table 71:
71: Project Investment Costs ('000 Birr)
Item Project Year
1 2 3 4 5 N
Land preparation X X X X X
Building X X X X X
Equipment X X X X X
Vehicles X X X X X
Working Capital X X X X X
Other costs X X X X X
Total XX XX XX XX XX XX

Generally speaking, the amount of funds required for operating needs varies from time to time
in every business. But a certain amount of assets in the form of working capital are always
required; if the business has to carry out its functions efficiently and without a break. The two
types of requirements are permanent (fixed) and variable.

The permanent working capital in that part of capital which is permanently locked up in the
circulation of current assets and in keeping it moving. On the other hand, variable working
capital changes with the volume of the output of the project.

2. Operating Costs/Production Costs.

Costs. Operating costs can be divided into two: Fixed
and Variable components. Variable working capital includes items such as materials,
power, labor inputs required for manufacture which will vary directly with the volume
of production while fixed costs will include maintenance, administration and
managerial charges, etc. which will be relatively fixed with respect to the volume of
production.

The total operating costs will then be the sum of the fixed and variable costs and will
increase over the operating years until full utilization of the investment asset is reached.

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 Table 7.2 Project Operating Costs Schedule
Years
No Items 1 2 3 4 5 N
Capacity Utilization Rate (%) 50% 75% 80% 85% 90% 100%
1 Raw material
2 Labor
3 Utilities
4 Repair
5 Maintenance and Repair
6 Factory Overhead
Factory Costs (1-6) (a) XX XX XX XX XX
7 Administrative costs
8 Sales costs
9 Distribution cost
Operating Costs (7-9) (b) XX XX XX XX XX
10 Depreciation (c)
11 Interest expenses (d)
Total production
Cost (a + b + c + d) (Bold) XX XX XX XX XX

Note:
Note: n represents the number of periods covered in the project appraisal.
As it is shown in the above schedule, operating cost includes: cost of production/cost of
sales, administrative expenses, selling expenses, depreciation on fixed assets, and write off
of preliminary and preoperative expenses.

a) Cost of Production
The cost of production includes
1. Material cost
2. Wages including salaries for executives
3. Utilities
4. Repairs and maintenance
5. Factory over heads. These items include expenses for the factory as:
- rent, for factory, if any
- insurance premium for factory assets and factory workers
- postage, telephone, fax, e-mail, etc, in the factory
- traveling expenses
- depreciation of plant and machinery and other factory equipment;
- proportionate management expenses, which may be charged to factory on the
basis of time spent by management on the project operation.

b) Administrative Expenses
This represents all indirect expenses incurred in the organization including estimates for
- salaries of all indirect staff
- postage, telephone, fax, e-mail etc

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 - traveling expenses
- insurance other than for the factory assets
- rent, rates, taxes, electricity etc and
- depreciations of all fixed assets other than factory assets other than factory fixed
assets

c) Selling Expenses
This represents estimated expenses in sales divisions as per projected organizations and
includes the items:
- salaries and personnel cost for sales staff and managers as planned
- publicity, advertisement, exhibitions, etc.
- subsidies, commissions, discounts to dealers, etc.
- administrative expenses of sales office including rent.
d) Depreciation
Depreciation expenses represent consumption of utility units contained in an asset. It relates
to the cost center where such assets are installed.

e) Production Build Up
In the first years of operation, a project may not be 100% build up or it may not utilizes the
full capacity. It build up over the years of its operation. From the technical details of the plant
and machinery and the available other resources as manpower, space etc. an estimation of the
plant’s installed capacity is worked out. Once the installed capacity is worked out, estimation
is made about the plant’s operation achieving from the initial zero to eighty or ninety percent
of the installed capacity. The peak is achieved in a span of three or four years from the start in
the phase manner – like 50%, 60%, 75%, 90% of the installed capacity – estimated by year 1,
2, 3, and 4 respectively. The capacity utilization factor is included in the projects operating
costs schedule.

3. Benefits
Benefits of a project can be several. For example, a range of different farm products in an
agricultural project, or cost savings as well as production benefit from a transport
infrastructure project. The different benefits will all be variable with respect to their
associated costs, and hence, total benefits will also be variable.

Benefits can be direct (production output) which may include items like:
- main product
- by product
- residual and other income

Benefits can also be indirect or external. For example, in a road projects reducing
transportation costs, reducing operating costs for maintenance of vehicles and saving time of
the society are indirect benefits of the project.

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Benefits are associated with the capacity utilization factor to which operating costs were also
related. When the value and timing of investment costs of and operating costs have been
determined the net benefits of the project can be calculated. The net benefit is computed by
simply subtracting the investment, operating and working capital costs from benefits.

The following table depicts the complete project resource statement, which brings together the
investment costs, operating costs, working capital and project benefits.

Table 7.3 Project Resource Statements

Project Period
No Items 1 2 3 4 5 6
1 Land preparation
2 Buildings
3 Equipment
4 Vehicles
5 Total investment cost
(1 + 2 + 3 + 4)
6 Factory costs
7 Administrative costs
8 Selling expenses
9 Depreciation
10 Total operating costs
(6 + 7 + 8 + 9)
11 Incremental working capital
12 Benefits
13 Net Benefits

The net benefits are negative in the first year’s whiles investment is taking place, and become
positive when the utilization of the new assets is building up.

Example on resource flow statement

Assume Zebra PLC has spent birr 75,000 on research in developing a new product. For the
purpose of financial analysis, the following information has been collected:
1. The fixed cost that will be incurred due to the product is birr 10,000 top cover insurance
and maintenance of new equipment

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 2. Advertising the new product will total birr 75,000 in first year, birr 50,000 in the second
year and birr 60,000 in the third year.
3. The new machinery will have to be purchased at cost of birr 650,000 and depreciates for
the next three years at straight line method and expected to have salvage value of birr
50,000 at the end of third year.
4. Sales of this product were estimated to be birr 2,000,000 in first year, birr 3,000,000 and
birr 4,000,000 in third years.
5. Variable costs to manufacture and sell this product were estimated to be 70% of the
sales in each year.
6. In addition to the main product, the organization gets benefit by selling by products.
Birr 25,000,10,000 and 15,000 in first, second and third years respectively

Required: prepare the resource flow of the project and give decision to accept or reject the
project based on this analysis. Answer: (385,000), 660,000 and 955,000 for first, second
and third respectively

5.2.2 Project Financial Statements

Financial analysis also involves formulation of various financial statements, which enable
project owners and other interested stakeholders to know whether the projects worthy or not.
Most commonly prepared financial statements are balance sheet, loss and profit statement,
and cash flow statements.

a) Profit and Loss Statements

The main purpose of profit and loss or trading profit and loss account in short income
statement is to calculate the profit or loss of enterprise or project. It is the measure of the
profitability of the project. Firms are required by law to prepare an income statement at the
end of each year to report to stakeholders on the performance and profitability of the project
and at the same time it is used to calculate the tax liability to the government. Borrowers also
use this income statement as the base to grant loans. An example of typical income statement
is given below.

XYZ Project
Profit and Loss Statements
Project Period
No Items 1 2 3 4 5 6 n
1 Total sales
2 Variable production cost

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 3 Gross profit (1-2)
4 Other production costs
5 Corporate tax
6 Net profit after tax (3 – (4 + 5)
7 Dividend
8 Retained profit (6-7)

The format of the profit and loss account varies according to who is preparing it and for what
purpose, and on the type of activity, be it manufacturing, retail or service projects. Gross
profit is calculated by deducting direct production costs (cost of sales) from sales revenue. Net
profit item (6) in the above schedule is calculated by deducting other operation costs, such as
over head costs including depreciation, loan interest and corporate tax from gross profit. The
last part of P/L account is the appropriation account, which shows how much of the net profit
is retained to be reinvested in the project and how much is distributed to stockholders.
b) Balance Sheet
Balance sheet is a statement of the assets and liabilities of the enterprise and gives "the net
worth" an enterprise at a point of time. It is prepared to present a picture of the firm on one
day in the year. The information represents the account balances recorded and does not
indicate exact economic values.

The balance sheet shows the way in which a project is financed, whether by sponsors, lenders
or creditors and how these funds have be employed. The sources of funds, even where they
represent the capital invested by shareholders are regarded as the liabilities of the company
and the use to which funds have been put are the assets.

The Balance Sheet is the key to understanding the financial position of a project or enterprise
unlike the profit and loss account, which shows how well a project has performed over a
period of time; the balance sheet is a measure of what the project is worth at a particular point
in time. This is done by comparing assets (what the project owns) and liabilities (what the
project owes). Balance sheet is usually prepared annually for project analysis and it is
considered by commercial bankers to be one of the most important statement when deciding
whether or not to invest in an existing project.

Balance sheets are presented in a number of different formats. An example of a typical

vertical format is shown below.
XYZ Project
Balance Sheet
On Sene 30, 1996 E.C
Years
No Items 1 2 3 4 5 6
1 Current Assets:

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 2 Cash
3 Inventories and supplies
4 Accounts receivables
5 Total current assets (2+3+4)
6 Fixed assets:
7 Building
8 Machinery and equipment
9 Other assets
10 Total fixed assets
(7 + 8 + 9)
11 Accumulated depreciation
12 Net book value of assets
(10 – 11)
13 Current liabilities:
14 Short term loan
15 Loan
16 Tax payable
17 Total current liability
(14 + 15 + 16)
18 Networking capital
(5 – 17)
19 Employment of funds
(18 + 12)
20 Funds employed:
21 Owners equity
22 Retained earnings
23 Term loans
24 Total funds
(21 + 22 + 23)

c) Cash flow statement

Finance is considered by many as the lifeblood of an organization or any project. A well
designed project may fail due to insufficient cash for its day to day operation. Therefore, a
project planner has to develop some techniques of forecasting cash in flows and out flows.
Cash flow statement is a basis for showing the cash flows associated with operating resources,
funding and investment.

Cash flow statements are prepared for two reasons:

First, it is prepared for financial planning purpose: in this case, the purpose is to know the
liquidity position of the project. It helps project planners to identify potential periods of cash
shortages and enables them to plan appropriate responses designed to remove such shortages
or how to utilize excess amount of fund during the life of the project.

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Secondly, cash flow statement may be prepared for the purpose of Net Present Value (NPV)
and Internal Rate of Return (IRR) calculation. The purpose here is to measure the overall
profitability of the project.

In general, cash flow statement is the main tool of financial planning and is sometimes
referred to as the "Source and application of funds statement". An example of a typical cash
flow statement is given below:

XYZ Project
Cash Flow Statement for Financial Planning ('000)
Years
No Items 1 2 3 4 5 6 n
1 Cash in flows
2 Financial sources:
3 Loans
4 Equity
5 Bank over draft
6 Supplies
7 Credit
8 Total in flow (2 + 3 + 4 + 5 + 6) XX XX XX XX XX
9 Cash out flows:
10 Operating costs (fixed and variable)
11 Debt service (Interest plus loan
repayment)
12 Corporate tax
13 Total assets
14 Dividend
15 Working capital (physical and financial)
16 Surplus or deficit (Net cash flow)
(7 – 14)
17 Cumulative cash balance
(151 + 152 + 153 etc)

The following schedule shows the cash flow statement prepared for NPV and IRR calculation.
XYZ Project
Cash Flow Statement for NPV and IRR Calculation
Years
No Items 1 2 3 4 5 6 7
1 Cash in flows XX XX XX XX XX XX XX
2 Cash out flow:
- total investment outlay
- operating costs
- corporate tax
- total cash out flow XX XX XX XX XX XX XX
3 Net cash flow (1 – 2) XX XX XX XX XX XX XX

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 4 Present value (PV) XX XX XX XX XX XX XX

Present value is the net cash flow of the project over its life subject to discounting. If you are
given the discounting rate say 10%, you can calculate discounting factors and then the present
value of the net cash flow of the project. Example: if the Net cash flow of the project is in its
first year of operation is Br. 100,000 and discounting rate is 10%, the present value of this
sum of money (at Zero period) is given by the formula:

PV = A (1 + r)-n Where:
PV = 100,000 (1 + 0.1)-1 A = Amount
= 100,000 (1.1)-1 or
r = discounting rate
= 100,000
1.1 PV = present value
= 90909.09Br n = number of periods for which the
amount of money is discounted

The value of the discounting factor (1+i) -n can (1 r)-n = is the either
be+determined discounting
using factor.
a calculator or a
financial table prepared for this purpose.

The cumulative cash flow must always show a positive balance. Because, a negative amount
indicates that the project has run out of cash. Cash flow statement records (cash in flow and
out flow) are presented on the cash basis of accounting not on the accruals concept, hence it
does not give an indication of profitability. It simply tells you the amount of cash available at
any one point in time and whether it is sufficient to be able to meet commitments as they fall
due. It is possible for a project to be profitable yet find itself short of cash when it is needed to
meet different types of operational commitments such as interest and loan repayments. This
may be because sales revenue has not been collected.

As it is shown in the above schedule, CFS can be prepared for IRR and NPV calculation
purpose to see whether the project is profitable or not. If a project has a negative cash flow but
is acceptable in terms of its IRR and NPV and profitable in terms of the net profit figures then
there are a number of options the project analyst can consider to improve the liquidity position
of the project. These are:
- increase owners equity
- increase long term and short term borrowing
- increase credit purchases
- reduce credit sales/discounts
- acquire machines and equipments on a rent or lease basis than purchase
- increase the grace period on loan
- increase loan repayment period
- reducing the amount of working capital

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 - improve inventory management etc.

d) Supporting statements/schedules
To prepare the three main financial statements the following supporting schedules and
additional information are required:
1. Depreciation schedule: it calculates the total amount of depreciation for all
project assets. This balance is deducted from the net profit figures in the
income statement. Therefore, in order to be able to complete the income
statement the annual total depreciation charges need to be calculated.
Depreciation is a means of charging the cost calculated. Depreciation is a
means of charging the cost of an asset against profit over a number of years. In
other words, it is a way of spreading costs over the entire life of the assets used
to produce the goods/services.

There are several methods employed to calculate depreciation and the choice
depends on the preferences of the project analyst and the requirements of the
taxation department of the government.
2. Taxation: the income statement is used to calculate the project's tax liability to
the government. The analyst should check for the rate (which is governed by
the government), tax holidays (number of years the project may be free from
paying tax) and whether or not losses from previous years can be carried
foreword.
3. Loan repayment schedule: in this schedule the loan disbursement and loan
repayment conditions should be stated and understood very well. Because, the
terms of the loan will affect the benefits received by the lender and by the
borrower.

5.3 Measures of project worth

Measures of project worth are measures that tell you whether a project is worth undertaking
form a particular viewpoint. All such measures are concerned with the question "are the
benefits greater than the costs?" There are different ways of measuring project worth, which
may fall under two categories, that is discounting cash flow methods and non discounted
(traditional) methods. They are briefly explained here in after.

5.3.1 Non-Discounted Measure of Project Worth

A) Payback period

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Payback period is one of the simplest method to find out the period by which the investment
on the project may be recovered from the net cash inflows, i.e., gross cash in flow less the
cash outflows. In short it is defined as the period required to recover the original investment
cost. Payback period starts with a preconceived notion that the management wants to recover
the cost of investment within a "specific period". When the analysis under such system shows
that the payback period is less than such "specified period", decision may be taken in favor of
the investment for such project.
The basic drawbacks of this method of financial analysis are:
1) The payback period is a very crude measure of project worth because it completely
ignores benefits/ cash flows after the period when the initial investment has been
repaid. Hence, it would be a very unreliable means for comparing two different
investments with different time profiles. It discriminates heavily against projects with
a long gestation period.
2) It ignores the time value of money

In spite of all the drawbacks mentioned above, this method is easy to understand, quick in
calculations and emphasizes in liquidity. The decision on "short term" investment can be
taken based on this method of financial analysis. There are two methods in use to calculate the
payback period.

 Unequal cash flows: In this situation the pay back period id calculated as:
Payback period = E + B/C
Where
E = number of years immediately preceding
the year of final recovery
B = the balance amount to be recovered
C = cash flow during the final recovery
Example:
Example: A company is considering investing on a particular project. The alternative projects
available are: Project A that costs Br. 100,000, and Project B that Costs Br. 70,000. The net
cash in flows estimates are as follows:

Net Cash Inflow

Year Project A Project B
1 30,000 7,000
2 30,000 15,000
3 35,000 20,000
4 35,000 56,000
5 40,000 45,000
Which project is good?

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Solution:
Project A Project B
Year Net cash inflow Accumulated Net cash inflow Accumulated
Net cash inflow Net cash inflow
1 30,000 30,000 7,000 7,000
2 30,000 60,000 15,000 22,000
3 35,000 95,000 20,000 42,000
4 35,000 130,000 56,000 98,000
5 40,000 170,000 45,000 143,000

Payback period for Project A:

Payback = 3 years + 5000*
period 35,000

= 3.14 year or 3 years and 2 months

Payback period for Project B

PP = 3 years + 28,000
56,000

= 3.5 year or 3 years and 6 months

Note: * represent the balance to be recovered from the cash inflow in period four; i.e.,
100,000 – 95,000 = 5,000

Uniform Cash flows

Where the annual cash flows are uniform, payback period can be calculated using the
formula:
PP = Original Investment
Annual Cash Flows
Example:
Example: A project requires an investment of Br. 200,000. It is expected to generate an
annual cash flow of Br. 50,000 per year over the life of the project. How long will it take to
recover the investment?

PP = Original Investment
Annual Cash Flows
= 200,000 Br
50,000
= 4 Years

B) Benefit cost ratio (B/C)

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This is a measure of efficiency and used for comparison of different projects. It is given by
the formula:

B/C = Benefits
Cost of the project

N.B. This approach can also be used to calculate discounted benefits and costs.

In general, non-discounted measures of project worth can be regarded as simplified short cuts
that can be used for rough approximations and decision making on small investments but they
are not appropriate quick look at on a feasibility viability of the project before you go to detail
analysis of the project carried out.
5.3.2 Discounted Measure of Project Worth
Before we are going to discuss discounted financial analysis techniques, let us discuss briefly
the concepts of discounting and compounding.

Money is one of the basic resources of an organization that has a time value. The time delay
between an outlay and its effect is the main reason for discounting and compounding future
benefits and costs.

To allow for the changes in the time value of money, the terms "present value" and "future
value" are used. To calculate the present value of future costs and benefits their future values
are "discounted" – reduced from constant price values – back to the present using a discount
rate. The concept of compounding is the opposite of discounting whereby in compounding,
the present value grows to a future value because of the accumulation of interest.
Compound Interest
Compound interest can be calculated using the following formula:
Future value = Present value x Compound factor
FV = PV (1 + r)t
Where
r = annual interest rate
t = time in years
Example:
Example: What will be the value of Br. 100,000 deposit in an account which pays 10%
Fv = future value
interest compounded for a period of three years time?
PV = present value
Solution:

PV = Br. 100,000
r = 10%
t = 3 years

FV = 100,000 (1 + 0.1)3

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 = 100,000 (1.1)3
= 133,100 Br
This is the amount that the account accumulates after three years the difference between the
original sum of money 100,000 Br. and 133,100 i.e., 33, 100 birr is the interest earned during
the period.

Discounting
The discount rate is the reciprocal of the compound factor and it is given by the following
formula:

PV = FV or FV (1 + r)-t
(1 + r)t

Example:
Example: what will be the present value of the profit of Br. 100,000 generated in the third
year of a project if the discount rate is 10%?

Solution:
Solution: Fv = 100,000 Br. r = 10%
t = 3 years Pv = ?
-3
PV = 100,000 (1.1)
= Br. 75,000
In a net shell, when you have streams of costs and benefits (cash inflows) for a project, and
you also have a measure of time preference (i.e., rate of discount) we can then discount the
cost and benefit streams to arrive at their discounted value as it is shown above. This
procedure is often described as "Discounted Cash Flows" or DCF.
The commonly used discounting methods are:
- Net Present Value (NPV)
- Internal Rate of Return (IRR) and
- Benefit Cost Ratio (BCR)
These are discussed in brief below.

i) Net Present Value (NPV): is the net sum of total discounted

benefits (cash inflows) and total discounted costs. It represents the present worth of an
investment in excess of the investment itself. The NPV method is a system of finding out
the excess (or short) of the present value of the earnings from the investments over and
above the present value of the investment itself.
Steps to find out the NPV
1. Find the project costs
2. Find the future cash flows as estimated for the projected business, net of cash outflows
3. Select an appropriate rate and a period to be considered for such evaluation to find the
present value of the future cash flows for the period by discounting by the selected rate

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 4. Find out the difference between the present value of cash inflows (net) and the
investment cost (present value of investments over the life of the project).This
Where:
difference represents NPV.
CF = Cash inflows at different periods
This calculation can be represented algebraically as:
r = discounting rate
CFt
NPV =   C0 C = cash outflow in the beginning
0

(1  r ) t NPV = Net Present Value

t = time period

The decision rule here is to accept a project if the NPV is positive and reject it if it is negative.
A project who NPV approaching zero is a marginal project. The planner has to remodify,
otherwise it will be very risk to take such projects.
Comments on the NPV Method
1. The NPV is easy to understand and calculate from the figures available in the project
schedule.
2. The basic drawbacks in this method are:
 Estimation of a discounting rate, which can be very much subjective, or need
to be obtained externally such as National Bank.
 The measure fails to indicate which project uses capital more efficiently or
which projects are closer to the margin of acceptability.
ii) Internal Rate of Return (IRR):
(IRR): is defined as the discount rate
the net present value is zero. IRR method finds out the rate at which – when applied on
future cash inflows – the present value of such inflows taken together should equal with
the present value of the cost of investment. It is called "Internal", as it is purely related to
the return of the particular projected investment only. In other words it is the rate at which
the project investment is just recovered. In essence it measures the efficiency of capital.
To calculate IRR we can use interpolation method using the following formula:
Lower Difference
IRR = discounting between + 
rate (DR) discount
MPVs at lower discount rate
rates
Absolute differences of MPVs at two discount rates
As you can see in the formula, you need to have two net present values i.e., positive and
negative NPVs that can be determined by the trial and error method. The higher the discount
rate is the lower NPV and the lower the discount rate is the higher the NPV. Interpretation
should be attempted arithmetically over a range of discount rates.

Example 1: NPV calculation

AMA company is considering to invest in a particular project. The initial investment cost is
Br. 100,000. It is expected that the project may generate a benefit for 5 years as shown below:
Year Operating cost Annual cash inflow
1 Br. 100,000 --
2 6,000 Br. 20,000
3 10,000 30,000

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 4 2,000 40,000
5 1,000 35,000
The discounting rate is 10%
Required: Calculate the NPV
The approach is discounting the cost and revenue streams separately. This is shown as
follows.
Year Cost Revenue Present Value PV of Cost PV of Revenue
(Cash in flows) Factor
0 Br. 100,000 -- 1 Br. 100,000 --
1 6,000 Br. 20,000 0.9091 5,454.6 Br. 18,182
2 10,000 30,000 0.8264 8,264 24,792
3 2,000 40,000 0.7513 3,756.5 30,052
4 1,000 40,000 0.6830 1,366 27,320
5 1,000 35,000 0.6209 620.9 23,905
Total Br. 119,462 Br. 124,251

Net present value of the project = PV of Revenue – PV of Costs

= 124,251 – 119,462
= Br. 4,789
Decision: If you are talking about only one project, the decision is to accept this project since
its NPV is positive (Br. 4,789).

A project's NPV varies with the discount rate usually the higher the discount rate then the
smaller the NPV. NPV method is used widely because it provides an absolute measure of the
surplus generated by the project. A project is acceptable at a given discount rate if the NPV is
positive.
Example 2: IRR Calculation
Using the same project data as in the example 1 above, determine the IRR? New line IRR can
be estimated approximately by interpolation from a few NPV calculations. This interpolation
is done mathematically. The arithmetic rule for interpolation between two discount rates, one
of which gives a positive NPV and the other of which gives a negative NPV, is as follows:

IRR = Lower rate DR + Difference between 

NPVs at lower DR
Where: DR = Discount rate
Absolute difference of NPV' s at two DR' s
Using the above data, it was found that the NPV at 10% was Br. 4789. Adopting a second trial
rate of discount 12%, the NPV is found to be (Br. 3201) which is negative.

Year Cost Revenue Present Value PV of Cost PV of Revenue

Factor Br. Br.
0 100,000 -- 1 100,000 --
1 6,000 20,000 0.8929 5,357 18,182
2 10,000 30,000 0.7972 7,972 24,792

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 3 5,000 40,000 0.7118 3,559 30,052
4 2,000 40,000 0.6355 1,271 27,320
5 1,000 35,000 0.5674 567 23,905
Total Br. 118,726 Br. 115,525

NPV at a 12% rate in 115,525 – 118,726 = (Br. 3201)

Therefore, IRR lies between 10% and 12% using the above formula; you can calculate IRR of
the project as follows:
IRR = 10% + (12% - 10%)  4789
= 10% + 2 4789 4789 –(-3201)
7990
= 10% + 2(0.5994)
= 10 + 2(0.5994)
= 11.2%
The IRR of the project is, therefore 11.2%. If the cost of capital is less than 11.2 it can be
accepted? If it is above , it should be rejected
III. Net Benefit-Cost Ratio
Net Benefit Cost Ratio (NBCR) linked to BCR. It is the ratio between NPV and initial
investment
NBCR= NPV/I

Where NBCR= net benefit cost ratio

I= initial investment
NPV = net present value
Three decision rules associated with NBCR criterion are
 If NBCR is greater than zero, the project is accepted.
 If the NBCR is equal to zero, the firm is indifferent to the project.
 If the NBCR is less than zero, the project is rejected.

Example: Consider the two mutually exclusive projects X and Y with the following cash
flow streams. The cost of capital for both the projects is 14%.
Year Project X Project Y

Cash PVIF Present Cash PVIF Present

Flow @14% value Flow @14% value

0 -155, 000 - 48,000

1 38,000 0.877 33,326 13,500 0.877 11,839.5
2. 44,000 0.769 33,836 14,700 0.769 11,304.
3. 49,000 0.675 33,075 17,300 0.675 11,677.5
4. 54,500 0.592 32,264 18,800 0.592 11,129.6

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5. 60,000 0.519 31,140 20,500 0.519 10,639.5

163,641 56,590.4
The NBCR of both the projects is calculated as follows:
Project X = Present Value / Initial Investment
= 163641/155000 = 1.05575
Project Y = Present Value / Initial Investment
= 56590.4/48000 = 1.17896
Though the NBCR of both the projects is more than 1, Project Y should be accepted as it has
a higher BCR than Project X.

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